Balancing the twin demands of risk and return

Investment has become more complex for trustees says Caroline Escott, defined benefit and investment policy lead at the Pensions and Lifetime Savings Association. That brings new benefits and challenges

Fifty years ago, the world was a simpler place for pension schemes. In 1967, more than 12 million public and private sector workers had a final salary pension. The combination of high interest rates and good stock market returns meant significant increases in the value of pension funds’ assets – mostly invested in a straightforward mix of UK equities and bonds – while pension scheme regulation was relatively light.

Life for schemes has become more complex since then. Longer-term trends such as greater financial market regulation, increasing longevity and changes to accounting standards, combined with the recent political and market volatility mean that most defined benefit schemes’ liabilities are growing faster than their assets. Pension schemes must achieve a balance between de-risking their portfolios to protect capital and boosting the return on their investments.

All this means that schemes are now pursuing more complex strategies, and it is increasingly normal for them to diversify by investing in ‘other’ assets, including emerging markets and infrastructure debt. Weak performance in certain asset classes after 2007-08 means that diversifying to other kinds of investments can reduce the risk across a portfolio. Looking to allocate to alternative income assets such as infrastructure or real estate debt can also result in an illiquidity premium.

The challenges inherent in ensuring sufficient portfolio diversification within the constraints of limited trustee resources has led to a proliferation of multi-asset strategies and products. These allow investors to diversify into a broad range of asset classes within either one fund (for instance in diversified growth funds) or using one primary manager (using a multi-asset credit strategy).

Choosing the right manager or fund still requires a great deal of care from trustees even if these vehicles, or others such as fiduciary management, provide ways to reduce the governance burden. The shift towards diversifying into more unusual asset classes can yield significant benefits in terms of risk-adjusted returns for schemes.

However, any strategy must be approached carefully and with a clear understanding of what the ultimate investment objective is. It is vital that trustees take the time to get their strategy right, as doing so is what will determine the long-term success of the scheme.

This opinion piece forms part of Engaged Investor’s new report on investment diversification. Click here to see the full report.

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